TECH STOCKS: 5 Ways Tech Startups Are Avoiding IPOs

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Opinion: While recent tech IPOs have popped, there is a lot of money available to companies that want to avoid the process

Don't let the recent strong initial public offerings fool you: Tech startups are still avoiding Wall Street en masse, and there is big money offering them investments to stay private in multiple ways.

Last week's debut of data-center company Switch Inc . brought in half a billion dollars for the third-largest tech IPO this year, and streaming-video device maker Roku Inc. saw its valuation double in its first two trading days . They follow more recognizable names that went public earlier this year and have struggled to live up to their initial valuations: Snapchat parent company Snap Inc.(>> Snap Inc) and meal-kit delivery company Blue Apron Holdings . These companies all bravely went forth, where even bigger companies still fear to tread.

However, the tech companies with some of the largest private valuations continue to sit on the sidelines, preferring to remain mostly silent on IPO plans. Uber Technologies Inc., Airbnb Inc., Pinterest Inc., Palantir Technologies Inc. and Dropbox Inc. are just a handful of companies valued at $10 billion or more in venture capital investments that have not publicly filed for an IPO, and there are dozens more companies with valuations of more than $1 billion.

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Instead, many of those so-called unicorns are looking for any other avenues to raise funds, avoiding the type of roller-coaster performance Snap has experienced, which could show that companies' lofty private valuations could mean a harsher reception from public investors when a deal gets to market. Even with the recent rebound in its shares , Snap still is trading below its IPO price of $17.

"There was a time when too much money was in the IPO market," said Kathleen Smith, principal at Renaissance Capital, a manager of IPO ETFs. "Now you might say there is a lot of excess capital in the private market, it has produced excessive private valuations that aren't holding up in the public market."

Last year was the worst drought in IPOs since a major downturn in 2009 resulting from the economic collapse. Jay Ritter, a Cordell professor of finance at the University of Florida, counts only 74 operating companies in the U.S. as going public in 2016, (https://site.warrington.ufl.edu/ritter/files/2017/08/IPOs2016Statistics.pdf) excluding entities like ADRs, closed-end funds, REITs, SPACs, penny stocks and others, the lowest since 2009.

This year has rebounded slightly. Through three quarters, 20 tech IPOS have raised $6.7 billion, according to Renaissance Capital, compared with 16 tech IPOs that raised $2.1 billion in the same period in 2016. There have been 121 total IPOs in the U.S. so far this year, raising $31.2 billion, compared with 102 total deals in 2016, raising $21.6 billion, according to data from PwC (http://usblogs.pwc.com/deals/declining-q3-ipo-activity-triggers-many-questions-q3-2017-capital-markets-watch/?WT.i_asset_id=AD.OD.NL_Q3%202017%20Capital%20Markets%20Watch_10FY18&WT.mc_id=5877&WT.i_dcsvid=deals%40braincomm.com).

"Based on the tech deals scheduled over the next two weeks -- CarGurus , LiveXLive Media, MongoDB, Sea -- and what we see in the pipeline, we think that 2017 could see twice the number of tech IPOs as in 2016," Smith said.

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Still, the total is unlikely to live up to previous years. According to PwC, there were 229 IPOs in 2013, 276 in 2014 and 169 in 2015.

That is not surprising, as companies with valuations in the unicorn stratosphere are fearful of experiencing a "down round" IPO like Cloudera Inc. (>> Cloudera Inc) , which went public at less than half the valuation it had received in a private investment led by Intel Capital . Those fears have helped change the attitude among tech entrepreneurs, who once embraced the IPO as a major event in growing a company.

"It is no longer that Holy Grail," said Barrett Daniels, Chief Executive of Nextstep Advisory, a consulting firm that advises companies on going public. "The way it currently works, it has become much more of a burden. The amount of work involved doesn't match up with the benefits that come out from the other side."

Daniels noted that because so much private money has been available, companies can get the funding they used to count on from an IPO from other avenues. Those avenues are multiplying seemingly by the day, and could disrupt the IPO market for years.

Right now, startups are keying on five distinct funding opportunities available to later-stage companies that want to avoid a traditional IPO.

1) Initial coin offerings. ICOs are using the cryptocurrency based on the Ethereum blockchain to raise funding from a range of investors at an increasing rate, as this list shows . Companies attract investors looking for the next big crypto score by releasing their own digital currency in exchange, typically, for an investment in bitcoin. In 2014, ethereum raised $18 million in bitcoin and is now trading with a market cap of about $19 billion. But ICOs probably represent the riskiest strategy, with a growing chorus of naysayers calling it a bubble.

2) The SoftBank Vision Fund. With $93 billion burning a hole in its pocket via a new fund, Japanese tech conglomerate SoftBank Group Corp. (>> SoftBank Group Corp) is helping many companies avoid going public for a while. Slack, the office messaging service, raised $250 million in a financing round led by SoftBank that valued the company at $5.1 billion. WeWork Companies Inc., which rents shared office spaces, received $4.4 billion from the SoftBank Vision Fund that valued the startup at $20 billion , and its chief executive explained that valuation in a way that probably would not fly on Wall Street.

"Our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue," Adam Neumann told Forbes (https://www.forbes.com/sites/stevenbertoni/2017/10/02/the-way-we-work/#30a65e811b18).

3) SPAC. Venture capital investors Chamath Palihapitiya and Ian Osborne recently went public with a special purpose acquisition company, or SPAC, called Social Capital Hedosophia . The company, formed as what is called a blank check company, has the mission of creating "an alternative path to a traditional IPO for disruptive and agile technology companies to achieve their long-term objectives and overcome key deterrents to becoming public."

In other words, the SPAC's only reason for being is taking the money it raised from Wall Street and buying an as-yet-unnamed startup or startups, or stakes in those companies. Much like investors who turn over capital to venture capital shops and hope that they find a winner, investors in Social Capital Hedosphia are doing the same.

4) A direct listing. Spotify AB, the streaming music company, is planning to resurrect the direct listing, which would place its shares directly on Wall Street without the formal process of an IPO. This kind of deal would provide liquidity for investors who lent the company money on the condition that it go public this year , but would not raise any new funds for the Stockholm-based company. Currently, the SEC is reviewing its plan and it could list later this year or early next year (https://www.bloomberg.com/news/articles/2017-08-21/sec-is-said-to-study-spotify-plan-to-bypass-ipo-in-nyse-listing), Bloomberg News recently reported.

5) Mergers and acquisitions. Getting acquired is by far the most frequent way that investors see returns on their private investments. According to Ted Smith, co-founder and president of Union Square Advisors, about 80% of young companies end up getting acquired while 20% go public, a general 80/20 rule that he says goes back as far as the mid-1990s.

"VCs are fairly cautious about the IPO market," Smith said. "Generally speaking, many of those are going to end up doing M&A." It isn't going to be another banner year for mergers, as it was in 2015 and 2016, he said, but there will still be a lot of deal activity.